Loan Covenant and Compliance – What You Need to Know
So, you have built your small business from the ground up and grown it to the point where you are seeking outside capital from a third-party lender such as a bank. While this will change the game and afford your company new opportunities and increased flexibility, there are a few things to prepare for as you begin the process of obtaining a loan or line of credit – namely “loan covenant” requirements. While it might seem like a lot to unpack, your CPA firm is here to help.
When a bank distributes capital in exchange for a promissory note they are essentially taking on risk (that the borrower may perhaps make late payments or might outright default on the loan). As a result, the lenders aim to reduce the risk on these loans to a lower level through writing covenants into these loan and line of credit agreements.
Covenants fall into two categories. “Affirmative covenants” require that the borrower provide something (“do this”). For instance, the borrower might need to maintain a specified level of insurance, the debt could be collateralized by some or all of the company assets, the bank could require a personal guarantee from one of the owners, or the bank could require you to report periodic financial information (see below). “Negative covenants” require that a borrower avoid doing something (“don’t do this”). In instances of negative covenants, certain financial ratios of the business must not fall below specified thresholds (discussed below). It is important to furnish all required information to the banks by the deadline they have imposed, as noncompliance with covenants could result in the bank calling the loan.
Financial Reporting Requirements
Affirmative covenants can vary, but some common reporting requirements from banks are that businesses provide:
- Company financial statements
The bank will generally require that year-end company financial statements (many times including a statement of cash flows and footnotes to the financial statements) be provided, and that an outside CPA firm has audited, reviewed, or compiled those financial statements. Further, they may require that quarterly company financial statements be provided, as well.
- Tax returns
Of the company and potentially of the owners
- Personal financial statements of the owners
The financial information contained in all three is inter-related, and it is important that there is consistency throughout. A trusted CPA firm can help your business navigate these waters.
Maintaining Certain Financial Ratios
Regarding those required financial statements mentioned above, the lender will have in mind some metrics or performance measurements that they do not wish to see their borrowers fall below. Some basic examples are as follows:
- Asset & liability based
Ratio based on calculation of total assets to total liabilities, or current assets to current liabilities. (Represents the relationship between company’s assets and their availability to cover obligations – 1:1, 1.5:1, 2:1, etc.)
- Interest coverage
Earnings before interest, taxes, depreciation, & amortization (“EBITDA”) divided by the sum of interest expense and the current portion of debt. (A ratio that measures the relationship between net income adjusted for certain non-cash items and the interest and principal amounts owed to the bank.)
- Tangible net worth
Total assets (less intangible assets) minus total liabilities. (Results in a dollar amount that seeks to represent the value of the company’s physical assets net of liabilities.)
Contact Us with Your Questions
If you have questions or need help with loan covenants, contact our professionals at The Innovative CPA Group at 203-489-0612. Or contact us online.